Dividends are so yesterday. As investors zero in on companies that can manage to grow in a pandemic, money migrates to Silicon Valley. There a disruption-driven company declaring its first dividend is seen as a symbol of surrender and declining growth prospects.
That’s all fine and well, unless you are a financial advisor’s retiree client who thought her portfolio would produce enough capital to fund her lifestyle. Compounding this dilemma is the reality that stock and bond prices are at record levels so they throw off chintzy income.
For individuals left to their own devices, the problem can be dangerous. “If people are going to invest in stocks for the dividends because bond yields are really low, then they did it even though they really wanted to invest in bonds but felt they didn’t have a choice,” says Chris Cordaro, CIO of Regent Atlantic.
A decade of quantitative easing followed by the last year of Modern Monetary Theory has upset traditional principles of finance. When Loomis Sayles Vice Chairman Dan Fuss surveys the landscape of income-producing assets, he sees “distortions in the relationships between long-term bonds, high-yield bonds and yield-oriented stocks.”
In his view, the junk bond market has started to exhibit “funny” patterns of behavior that give him cause for concern. That’s why Fuss, an award-winning bond investor who once managed Yale’s endowment, thinks dividend-paying stocks probably are more attractive, even if many are hardly a bargain.
Growth Vs. Yield
Like every other financial asset, many dividend-paying stocks are expensive. Valuations are “stretched by many metrics,” says Michael Barclay, senior portfolio at Columbia Threadneedle.
Most managers of equity income funds interviewed for this article favor the dividend growth style over pure income plays. That’s partly because investors too narrowly focused on income can head toward value traps, says Tony DeSpirito, manager of BlackRock’s Equity Dividend Fund.
Value traps come with a number of red flags, according to DeSpirito: when a company has dividend payout ratios too high to sustain; if it has high debt levels that can pose refinancing challenges; and if it is a low-quality business with poor returns on invested capital. As investors desperately sought income over the last decade, tobacco companies “got way overvalued.”
One of the biggest value traps in many equity income funds five years ago was General Electric. A year before its stock got crushed in 2017, Michael Barclay bailed out. “In September 2016, the cash flow from its power generation business collapsed and we couldn’t see it recovering,” he recalls.
Other aspects of its business, notably GE Finance, looked like a Rubik’s Cube. “It was very hard to analyze,” Barclay says. That always left him “skeptical” about the conglomerate’s huge, opaque financial arm. More recently, cash flow concerns prompted Columbia Threadneedle to also unload ExxonMobil, another once-proud giant now facing serious questions about its generous 6.9% dividend.
Dividend cuts are usually a death knell for companies, but things have played out somewhat differently during the pandemic. Confronted with a lack of clarity about its business last spring, Estée Lauder eliminated its payout for a single quarter and then reinstated it.